Academic journal article Academy of Accounting and Financial Studies Journal

On Commodities, Risk Management, and Derivatives

Academic journal article Academy of Accounting and Financial Studies Journal

On Commodities, Risk Management, and Derivatives

Article excerpt

ABSTRACT

We often assume that risk is beyond the control of farmers. Farmers are exposed to weather, unpredictable changes in seed prices, tax rates, technology, fuel prices, chemical prices, and constantly changing commodity prices, Brorsen and Irwin (1996). However to some extent, farmers can control some of their risks by the use of financial instruments for hedging, Bessembinder (1992). Farmers can consciously affect the risk of their equipment by building in flexibility.

In the next section, hedging will be explained. In the following sections, options, futures contracts, (forward contracts, a specialized financial instruments that have been devised to help manage risk), and derivatives will be described. Each of these instruments provide a payoff that depends on the price of some underlying commodity (corn in the following examples). Because their payoffs derive from the prices of other assets, these instruments are often known collectively as derivative instruments (or derivatives for short). Derivatives often conjure up an image of wicked speculators, and they attract their share of speculators (some of whom may be wicked). But derivatives are also used by sober and prudent farmers who simply want to reduce risk.

WHY HEDGE?

Some risk can be hedged or offset. The idea behind hedging is straightforward. First, two closely related assets are found. Then, one asset is purchased and the other sold in proportions that minimize the risk of the net position. If the assets are perfectly correlated, the net position can be risk free. However, hedging is seldom free, Smith and Stultz (1985). Most farmers hedge to reduce risk, that is to reduce uncertainty, Martines-Filho (1996). Why then bother to hedge? For one thing, reducing the risk makes financial planning easier and reduces the odds of an costly shortfall. A shortfall might mean only an unexpected trip to the bank, but in extreme cases it could trigger bankruptcy. Why not reduce the odds of these awkward outcomes with a hedge?

Financial distress can result in indirect as well as direct costs to a farmer. (Direct costs include legal fees and administrative costs. Indirect costs reflect the difficulty of managing a farm under watchful eyes of a "friendly" banker). Costs of financial distress arise from disruption to normal farming operations as well as from the effect financial distress has on the farmer's investment decisions. The better the risk management policies, the less risk and expected costs of financial distress. As a side benefit, better risk management increases the farmer's debt capacity.

In some cases hedging also make it easier to decide whether the farmer deserves a stern lecture or a pat on the back. Hedging extraneous events can help focus the farmer's attention. While the farmer should not have to worry about events outside of his control, most people (and farmers are people) worry anyway. It is naive to expect the farmer not to worry about changing corn prices if his "bottom line" depends on them. Still, the time spent worrying could be better spent if the farmer hedged against such movements.

REDUCING RISK WITH OPTIONS

Farmers regularly buy options on commodities to limit their downside risk. Many of these options are traded on option exchanges, but often they are simply private deals among farmers, millers and bankers.

Suppose your neighbor, and employee of Illinois Milling, Incorporated (IMI), is concerned about potential increase in the price of corn, which is one of its major inputs, Gerht and Good (1993). To protect IMI against such increases, your neighbor on behalf of IMI buys 6-moth options to purchase 1,000 bushels of corn at an exercise price of $2 per bushel. These options might cost $0.10 per bushel.

If the price of corn is above the $2 exercise price when the option expires, IMI will exercise the option and receive the difference between the corn price and the exercise price. …

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